similar lawsuits. All three of these lawsuits
were consolidated into a single lawsuit captioned In Re ADC Telecommunications, Inc. ERISA Litigation. This lawsuit has been brought by
individuals who seek to represent a class of participants in our Retirement Savings Plan who purchased our common stock as one of the investment
alternatives under the Retirement Savings Plan from February 2000 to present. The lawsuit alleges a breach of fiduciary duties under the Employee
Retirement Income Security Act. On February 2, 2004, we filed a motion to dismiss this lawsuit, which was denied by the court. This case is now in the
discovery phase. The class has not yet been certified.
On June 6, 2005, the Eighth Circuit Court of Appeals
upheld a decision of the United States District Court for the District of Minnesota to dismiss another class action suit brought against us. This
lawsuit was brought by Wanda Kinermon in March 2003. The complaint named ADC, William J. Cadogan, our former Chairman and Chief Executive Officer, and
Robert E. Switz, our current Chief Executive Officer and former Chief Financial Officer, as defendants. After this lawsuit was served, we were named as
a defendant in 11 other substantially similar lawsuits. These shareowner lawsuits, including the suit brought by Ms. Kinermon, were consolidated into a
single lawsuit captioned In Re ADC Telecommunications, Inc. Securities Litigation. The lawsuit purported to bring suit on behalf of a class of
purchasers of our publicly traded securities from August 17, 2000 to March 28, 2001. The complaint alleged that we violated the securities laws by
making false and misleading statements about our financial performance and business prospects during this period. It is unclear at this time whether
plaintiffs will attempt to appeal the decision of the Eighth Circuit Court of Appeals.
We are a party to various lawsuits, proceedings and
claims arising in the ordinary course of business or otherwise. As of April 29, 2005, we had recorded $5.4 million in loss reserves in the event of
such adverse outcomes in these matters. At this time we believe the ultimate resolution of these lawsuits, proceedings and claims will not have a
material adverse impact on our business, results of operations or financial condition. However, litigation by its nature is uncertain, and we cannot
predict the ultimate outcome of these matters, or any potential liability associated with the same, with any certainty.
Income Tax Contingencies: Our effective tax
rate is impacted by reserve provisions and changes to reserves, which we consider appropriate. We establish reserves when, despite our belief that our
tax returns reflect the proper treatment of all matters, we believe that the treatment of certain tax matters is likely to be challenged and that we
may not ultimately be successful.
Significant judgment is required to evaluate and
adjust the reserves in light of changing facts and circumstances, such as the progress of a tax audit. Further, a number of years may lapse before a
particular matter for which we have established a reserve is audited and finally resolved. While it is difficult to predict the final outcome or the
timing of resolution of any particular tax matter, we believe that our reserves reflect the probable outcome of known tax
contingencies.
Other Contingencies: As a result of the
divestitures discussed in Note 4, we may incur charges related to obligations retained based on the sale agreement. At this time, none of those
obligations are reasonably estimable.
Change of Control: Our Board of Directors has
approved the extension of certain employee benefits, including salary continuation to key employees, in the event of a change of control of
ADC.
Note 16 — Subsequent Events:
On May 9, 2005, we announced the acquisition of
OpenCell, Corp. (“OpenCell”), a manufacturer of digital fiber-fed Distributed Antenna Systems and shared multi-access radio frequency network
equipment, from Crown Castle International Corp. OpenCell employs approximately 32 people and is based in Nashua, New Hampshire. We acquired OpenCell
for $7.25 million in cash, subject to purchase price adjustments.
On April 18, 2005, our Board of Directors committed
to a plan that directs our management to explore the sale or shutdown the operations of our subsidiary, ADC Systems Integration UK Limited. On May 24,
2005, we completed the sale of this business to a company controlled by one of its former owners from whom we purchased the business in our fiscal year
2000.
17
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND
RESULTS OF OPERATIONS
Overview
We are a leading global provider of communications
network infrastructure solutions and services. Our products and services connect communications networks over copper, fiber, coaxial and wireless media
and enable the use of high-speed Internet, data, video and voice services by residences, businesses and mobile communications subscribers. Our products
include fiber optic, copper and coaxial based frames, cabinets, cables, connectors, cards and other physical components essential to enable the
delivery of communications for wireline, wireless, cable, broadcast and enterprise networks. Our products also include network access devices such as
high-bit-rate digital subscriber line and wireless coverage solutions. Finally, we provide professional services relating to the design, equipping and
building of networks, which compliments our hardware business by planning, deploying and maintaining communications networks.
Our customers include local and long-distance
telephone companies, private enterprise networks, cable television operators, wireless service providers, new competitive service providers,
broadcasters, governments, system integrators and communications equipment manufacturers and distributors. We offer broadband connectivity systems,
enterprise systems, wireless transport and coverage optimization systems, business access systems and professional services to our customers through
the following two reportable business segments:
• |
|
Broadband Infrastructure and Access; and |
• |
|
Professional Services (previously known as Integrated
Solutions). |
Our Broadband Infrastructure and Access business
provides network infrastructure products for wireline, wireless, cable, broadcast and enterprise network applications for the communications industry.
These products consist of:
• |
|
connectivity systems and components that provide the
infrastructure to networks to connect Internet, data, video and voice services over copper, coaxial and fiber-optic cables, and |
• |
|
access systems used in the last mile/kilometer of wireline and
wireless networks to deliver high-speed Internet, data and voice services. |
Our Professional Services business provides
integration services for broadband, multiservice communications over wireline, wireless, cable and enterprise networks. Professional services are used
to plan, deploy and maintain communications networks that deliver Internet, data, video and voice services.
Marketplace Conditions
Our operating results for the three and six months
ended April 29, 2005 reflected significant sales growth when compared with the same period in prior years, even when excluding sales of KRONE which we
acquired in the third quarter of fiscal 2004. Our net sales and income for the three months ended April 29, 2005 showed significant growth across the
majority of our product and service offerings. While we expect a continuation of year over year sales growth into the future, we are uncertain whether
sequential or year over year sales growth will continue at the same rates we experienced in the three and six month periods ended April 29,
2005.
We believe that there is a general trend in our
industry toward modest overall spending increases from the historical low levels experienced from fiscal 2001 through fiscal 2003. However, it is
important to recognize that overall spending on communications equipment and services remains at significantly lower levels than existed prior to
fiscal 2001 and that customers appear to be selective about areas where they are willing to increase spending. Specifically, we believe that spending
increases by our customers are likely to be more pronounced in fiber-to-the-X (i.e., the deployment of fiber based networks closer to the ultimate
consumer which is sometimes referred to as “FTTX”) initiatives as well as in the wireless and enterprise areas. We also believe that as
capital spending budgets remain constrained, any increases in specific areas may cause service providers to decrease spending in other areas. For
instance, we believe initiatives to spend on FTTX projects may be causing decreases in spending on other wireline initiatives. Ongoing consolidation
among communications service providers may cause such companies
18
to defer spending while they focus on
integrating combined businesses. To date, deferred spending caused by customer consolidation has not adversely impacted our sales, but at least some of
companies in our industry appear to be experiencing this problem. In addition, our industry continues to experience very intense competition and
increased pricing pressure from our customers. Thus, while we do expect the overall market for spending on communication equipment and services to grow
year over year at least slowly in the near term, certain developments may adversely impact the rate of future sales growth as well as place pressure on
gross profit margins.
While we are cautious about our ability to be
successful in achieving continued revenue growth, we do believe several factors may provide us with the opportunity to increase our sales faster than
growth in the overall market in the near term. We believe such sales growth could be achieved through:
• |
|
New product offerings, such as our OmniReach™ FTTX
solutions being deployed by several communications service providers and the growing acceptance of our Digivance® wireless coverage solution and
our TrueNet® and CopperTen™ enterprise solutions; |
• |
|
Opportunities to cross-sell products among ADC’s
traditional customer base and the traditional customer base of KRONE following our acquisition in May 2004; and |
• |
|
Increasing our market share in certain areas as we have recently
done with respect to some of our product lines. |
We continue to be dependent on telecommunications
service providers for a majority of our sales, although this dependence has recently declined because of our KRONE acquisition. The four major U.S.
telephone companies (Verizon, BellSouth, Qwest and SBC) accounted for 25.9% and 28.6% of our sales for the six months ended April 29, 2005 and April
30, 2004, respectively. In addition, our top ten customers accounted for approximately 41.4% and 45.5% of our net sales for the six months ended April
29, 2005 and April 30, 2004, respectively. The decline in these customer concentration levels from 2004 to 2005 is largely due to the KRONE
acquisition, which gave us a more diversified customer base throughout the world. However, the increased diversification may be offset by mergers among
our customers. The long-term impact of such mergers on our business is difficult to predict. In addition, in the product areas where we believe the
potential for sales growth is most pronounced (e.g. FTTX initiatives and wireless products), our sales remain highly concentrated with the large U.S.
telephone companies.
We are continuing to focus on ways to conduct our
operations more efficiently and to reduce costs. During the downturn in communications equipment spending from fiscal 2001 through fiscal 2003, we took
significant cost-reduction measures. We believe most of our restructuring activity is completed, but will continue to pursue expense reductions. For
example, the integration of the KRONE acquisition has presented opportunities to reduce costs through the consolidation of duplicative facilities, the
movement of operations into lower cost locations as well as the elimination of duplicative processes and personnel functions. Accordingly, we
anticipate incurring additional restructuring charges in future periods.
Following our acquisition of KRONE in fiscal 2004,
we intend to continue to explore additional product line or business acquisitions that are complimentary to our communications infrastructure business.
For instance, we recently completed the acquisition of OpenCell for $7.25 million in cash. We believe this purchase will enhance our Digivance wireless
coverage solution offering. We expect to fund other potential acquisitions with existing cash resources, the issuance of shares of common or preferred
stock, the issuance of debt or equity-linked securities or through some combination of these alternatives. In addition, we will continue to monitor all
of our businesses and may determine it appropriate to sell or otherwise dispose of certain operations. For example, in April 2005 we announced our
intention to either sell or close our professional services operations in the United Kingdom when it became apparent we would not be able to generate
and maintain positive operating income through this business. On May 24, 2005, we completed the sale of this business to a company controlled by one of
its former owners from whom we purchased the business in our fiscal year 2000.
Prior to the downturn in our business beginning in
fiscal 2001, our results of operations had been subject to seasonal factors, with stronger demand for our products during our fourth fiscal quarter
(primarily as a result of customer budget cycles and our fiscal year-end initiatives) and weaker demand for our products during our first fiscal
quarter (primarily as a result of the number of holidays in that quarter, our customers’ development of annual capital budgets during that period
and a general industry slowdown during that period). This seasonality in our
19
business returned in fiscal 2004. At this time
we are uncertain whether we will see the same seasonal pattern in our fiscal 2005. It appears that our customers may have advanced some of their annual
spending into our second quarter and we presently are not certain whether we will see sequential revenue increases in our third and fourth quarters. We
do, however, still expect to post significant year over year revenue and income growth during our third and fourth quarters when compared against the
prior periods in our fiscal 2004. A more detailed description of the risks to our business related to seasonality, along with other risk factors
associated with our business, can be found in Exhibit 99 of this form 10-Q.
Results of
Operations
Net Sales
The following table sets forth our net sales for the
three and six months ended April 29, 2005 and April 30, 2004 for each of our segments described above (in millions):
|
|
|
|
Three Months Ended
|
|
|
|
|
|
April 29, 2005
|
|
April 30, 2004
|
|
|
|
|
|
Net Sales
|
|
%
|
|
Net Sales
|
|
%
|
Broadband
Infrastructure and Access |
|
|
|
$ |
248.7 |
|
|
|
78.8 |
% |
|
$ |
119.7 |
|
|
|
77.9 |
% |
Professional
Services:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Product |
|
|
|
|
15.8 |
|
|
|
5.0 |
|
|
|
8.8 |
|
|
|
5.7 |
|
Service |
|
|
|
|
51.2 |
|
|
|
16.2 |
|
|
|
25.1 |
|
|
|
16.4 |
|
Total
Professional Services |
|
|
|
|
67.0 |
|
|
|
21.2 |
|
|
|
33.9 |
|
|
|
22.1 |
|
Total
|
|
|
|
$ |
315.7 |
|
|
|
100.0 |
% |
|
$ |
153.6 |
|
|
|
100.0 |
% |
|
|
|
|
Six Months Ended
|
|
|
|
|
|
April 29, 2005
|
|
April 30, 2004
|
|
|
|
|
|
Net Sales
|
|
%
|
|
Net Sales
|
|
%
|
Broadband
Infrastructure and Access |
|
|
|
$ |
435.0 |
|
|
|
77.8 |
% |
|
$ |
222.7 |
|
|
|
76.7 |
% |
Professional Services:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Product |
|
|
|
|
29.4 |
|
|
|
5.3 |
|
|
|
17.2 |
|
|
|
5.9 |
|
Service |
|
|
|
|
94.7 |
|
|
|
16.9 |
|
|
|
50.4 |
|
|
|
17.4 |
|
Total
Professional Services |
|
|
|
|
124.1 |
|
|
|
22.2 |
|
|
|
67.6 |
|
|
|
23.3 |
|
Total |
|
|
|
$ |
559.1 |
|
|
|
100.0 |
% |
|
$ |
290.3 |
|
|
|
100.0 |
% |
Net sales were $315.7 million and $559.1 million for
the three and six months ended April 29, 2005, respectively, and increased 105.5% (or 34.2% exclusive of the KRONE acquisition) and 92.6% (or 22.9%
exclusive of the KRONE acquisition), respectively, over the comparable 2004 periods. The KRONE acquisition accounted for 67.6% and 75.3% of the net
sales increase over the comparable three and six months periods in 2004. Excluding the KRONE acquisition, our sales growth for the three and six months
ended April 29, 2004, was driven by strong broad-based growth among our comprehensive communication infrastructure solutions. International sales
comprised 44.7% and 29.8% of our net sales for the three months and 47.4% and 29.6% of our net sales for the six months ended April 29, 2005 and April
30, 2004, respectively. The increase in international sales primarily is due to our acquisition of KRONE, which has a greater mix of international
sales.
Net sales of Broadband Infrastructure and Access
products increased 107.8% and 95.3%, respectively for the three and six months ended April 29, 2005 over the comparable 2004 periods. Our Broadband
Infrastructure and Access segment includes infrastructure (connectivity) and access (wireless and wireline) products. The KRONE acquisition accounted
for 71.8% and 80.8% of the net sales increase of Broadband Infrastructure and Access products over the comparable three and six months periods in
2004.
Net sales of connectivity products increased 165.3%
and 153.5% for the three and six months ended April 29, 2005, respectively, over the comparable 2004 periods. The KRONE acquisition accounted for 70.2%
and 75.4%
20
of the net connectivity increase over the
comparable three and six months periods in 2004. Sales of our fiber connectivity products represented 21.7% and 20.6%, respectively of the net
connectivity increase over the comparable three and six months periods in 2004. This fiber sales increase was boosted by increased sales of our FTTX
products, which had minimal sales in the comparable 2004 periods.
Net sales of wireless products were $18.5 million
and $25.0 million for the three and six months ended April 29, 2005, respectively, and increased 54.2% and 24.4%, respectively, over the comparable
2004 periods. The increase in wireless product line sales was a result of improved demand for our Digivance product line due to the timing of product
development and production for our new dual band product as well as an improved supply chain for certain Digivance components. Sales of our Digivance
product lines are continuing to grow from deployments in large North American cities through Verizon and Nextel.
Net sales of wireline products decreased 34.7% and
39.2% for the three and six months ended April 29, 2005, over the comparable 2004 periods. The decrease in wireline product sales was caused primarily
by a general industry-wide decrease in the market demand for high-bit-rate digital subscriber line products as carriers undertake product substitution
by delivering fiber and internet protocol services closer to end user premises.
Net sales of Professional Services products
increased by 97.6% and 83.6% for the three and six months ended April 29, 2005 over the comparable 2004 periods. The KRONE acquisition represents 51.1%
and 54.7% of the increase in net sales of Professional Services products over the comparable three and six months periods in 2004. In addition, market
share gains with several legacy customers contributed to the increase in sales.
Gross Profit
During the three and six months ended April 29,
2005, our gross profit percentages were 37.1% (or 38.6% exclusive of the KRONE acquisition) and 35.5% (or 36.7% exclusive of the KRONE acquisition),
respectively compared to 40.8% and 40.1%, respectively, for the comparable 2004 periods. The decrease in the gross profit percentage primarily was due
to increases in sales of lower margin products caused by the KRONE acquisition and increased sales from FTTX products and Professional Services as well
as from the decrease in sales of our wireline products which have relatively high margins. The mix of products we sell in any one quarter is variable
and is difficult to predict accurately.
Operating Expenses
Total operating expenses for the three and six
months ended April 29, 2005, were $85.6 million and $165.0 million, respectively, representing 27.1% and 29.5% of net sales, respectively. Total
operating expenses for the comparable 2004 periods, were $65.8 million and $111.3 million, respectively. KRONE operating expenses were $25.7 million
and $51.1 million for the three and six months ended April 29, 2005, respectively. Excluding the effect of the KRONE operating expenses, operating
expenses (decreased) increased (9.0)% and 2.3%, respectively, compared to 2004 periods due mainly to the change in selling and administration expenses
discussed below.
Research and development expenses were $18.2 million
and $33.4 million for the three and six months ended April 29, 2005, respectively, or an increase of 27.3% and 25.1% over comparable 2004 periods. The
increases were almost entirely attributable to spending on projects related to KRONE based products as we did not close on our acquisition of KRONE
until the third quarter of our fiscal 2004. We believe that, given the rapidly changing technological and competitive environment in the communications
equipment industry, continued commitment to product development efforts will be required for us to remain competitive. Accordingly, we intend to
continue to allocate substantial resources, as a percentage of our net sales, to product development in each of our segments while directing most of
our research and development towards projects that we believe directly advance our strategic aims and have a higher probability to return our
investment because of our beliefs about segments in the marketplace that are most likely to grow.
Selling and administration expenses were $63.6
million and $124.6 million for the three and six months ended April 29, 2005, or an increase of 59.4% (or 3.3% exclusive of the KRONE acquisition) and
75.0% (or 10.3% exclusive of the KRONE acquisition) over comparable 2004 periods. The increase in selling and administrative expenses is primarily due
to incentives that have been partially offset by a decrease in the number of facilities. In addition, in fiscal 2004, there were $6.0 million of
one-time benefits primarily due to bad debt recoveries.
21
In fiscal 2005, we expect to incur added
administrative expense, including external fees that we expect to be approximately $3.0 million, associated with the requirements to comply with
Section 404 of the Sarbanes-Oxley Act of 2002. Compliance with Section 404 will require us to conduct a thorough evaluation of our internal control
over financial reporting, and we are and will be working with independent advisors in this process.
Restructuring charges were $3.2 million and $6.4
million for the three and six months ended April 29, 2005, respectively, compared to $10.1 million and $11.9 million for the three and six months ended
April 30, 2004. Restructuring charges relate principally to employee severance costs and facility consolidation costs resulting from the closure of
facilities and other workforce reductions attributable to our efforts to reduce costs. During the three and six months ended April 29, 2005,
approximately 36 and 75 employees were impacted by reductions in force, principally in our Broadband Infrastructure and Access segment. During the
three and six months ended April 30, 2004, approximately seven and 38 employees were impacted by reductions in force, principally in corporate
functions.
Other Income, Net
Other income, net consists of the following (in
millions):
|
|
|
|
Three Months Ended
|
|
Six Months Ended
|
|
|
|
|
|
April 29, 2005
|
|
April 30, 2004
|
|
April 29, 2005
|
|
April 30, 2004
|
Interest
income, net |
|
|
|
$ |
1.5 |
|
|
$ |
1.5 |
|
|
$ |
2.4 |
|
|
$ |
2.3 |
|
Foreign
exchange income (loss) |
|
|
|
|
0.1 |
|
|
|
(0.7 |
) |
|
|
1.3 |
|
|
|
(1.9 |
) |
Gain on sale
of note receivable |
|
|
|
|
— |
|
|
|
— |
|
|
|
9.0 |
|
|
|
— |
|
Gain on sale
of product lines |
|
|
|
|
— |
|
|
|
0.1 |
|
|
|
0.6 |
|
|
|
3.4 |
|
Gain on sale
of investments |
|
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
4.4 |
|
Gain (loss) on
sale of fixed assets |
|
|
|
|
3.8 |
|
|
|
(0.1 |
) |
|
|
4.3 |
|
|
|
0.3 |
|
Other |
|
|
|
|
— |
|
|
|
(0.2 |
) |
|
|
0.2 |
|
|
|
(0.1 |
) |
Total
Other Income, Net |
|
|
|
$ |
5.4 |
|
|
$ |
0.6 |
|
|
$ |
17.8 |
|
|
$ |
8.4 |
|
During the three months ended January 28, 2005,
fully reserved notes receivable of $15.8 million were sold resulting in a gain on sale of $9.0 million.
Income Taxes
Our effective income tax rate from continuing
operations for the three and six months ended April 29, 2005 was 6.3% and 6.5%, respectively, compared to (19.2)% and 2.9% for the comparable 2004
periods. Substantially all of our income tax provision for the three and six months ended April 29, 2005 is due to foreign income taxes. Our effective
income tax rate has been reduced by changes in the valuation allowance recorded for our deferred tax assets. See Note 9 to the financial statements for
a detailed description of the accounting standards related to our recording of the valuation allowance. Beginning in fiscal 2002, we have not recorded
income tax benefits in most jurisdictions where we have incurred pretax losses since the deferred tax assets generated by the losses have been offset
with a corresponding increase in the valuation allowance. Likewise, we have not recorded income tax expense in most jurisdictions where we have pretax
income since the deferred tax assets utilized to reduce income taxes payable have been offset with a corresponding reduction in the valuation
allowance. We will continue to maintain a nearly full valuation allowance on our deferred tax assets until we have sustained a level of profitability
that demonstrates our ability to utilize the deferred assets in the future. Until that time, we expect our effective income tax rate will be
substantially reduced. In addition, our deferred tax assets of $1,050.4 million, which are nearly fully reserved at this time, should reduce our income
taxes payable in future years.
Discontinued Operations
BroadAccess40
During the first quarter of fiscal 2004, we entered
into an agreement to sell our BroadAccess40 business, which was included in our Broadband Infrastructure and Access segment. We classified this
business as a discontinued operation beginning in the first quarter of fiscal 2004. This transaction closed on February 24, 2004. We
recorded
22
a loss on the sale of the business of $3.6
million based on the value of the business’ assets and liabilities as of January 31, 2004. Subsequent to January 31, 2004, adjustments of $3.0
million were made to increase the previous loss recorded.
The purchasers of the BroadAccess40 business
acquired all of the stock of our subsidiary that operated this business and assumed substantially all liabilities associated with this business, with
the exception of a $7.5 million note payable that was paid in full by us prior to the closing of the transaction. The purchasers issued a promissory
note to us for $3.8 million that was paid to us in full in May of 2005.
Cuda/FastFlow
During the third quarter of fiscal 2004, we entered
into an agreement to sell the business related to our Cuda cable modem termination system product line and related FastFlow Broadband Provisioning
Manager software, to BigBand Networks, Inc. (“BigBand”). This transaction closed on June 29, 2004. The business had been included in our
Broadband Infrastructure and Access segment. As consideration for this sale, we were issued a non-voting minority interest in BigBand, which we
accounted for under the cost method and has a nominal value. We also provided BigBand with a non-revolving credit facility of up to $12.0 million with
a term of three years. As of April 29, 2005, $7.0 million was drawn on the credit facility. We classified this business as a discontinued operation
beginning in the third quarter of fiscal 2004, and recorded a loss on sale of $2.6 million. In the fourth quarter, adjustments of $2.3 million were
made to increase the total loss to $4.9 million.
Singl.eView
During the third quarter of fiscal 2004, we entered
into an agreement to sell the business related to our Singl.eView product line to Intec Telecom Systems PLC (“Intec”) for a cash purchase
price of $74.5 million, subject to purchase price adjustments. The transaction closed on August 27, 2004. This business had been included in our
Professional Services segment. We also agreed to provide Intec with a $6.0 million non-revolving credit facility with a term of 18 months. As of April
29, 2005, $4.0 million was drawn on the credit facility. We classified this business as a discontinued operation in the third quarter of fiscal 2004.
In the fourth quarter of fiscal 2004, we recognized a gain on sale of $61.7 million. In our first quarter of fiscal 2005, we recognized an income tax
benefit of $3.1 million relating to resolution of certain income tax contingencies.
Metrica
During the fourth quarter of fiscal 2004, we entered
into an agreement to sell the business related to our Metrica service assurance software group to Vallent Corporation (formerly known as WatchMark
Corporation) (“Vallent”) for a cash purchase price of $35.0 million, subject to purchase price adjustments, and a $3.9 million equity
interest in Vallent. The transaction closed on November 19, 2004. The equity interest constitutes less then a five percent ownership in Vallent. This
business had been included in our Professional Services segment. We classified this business as a discontinued operation in the fourth quarter of
fiscal 2004. In the first quarter of fiscal 2005, we recognized a gain on sale of $36.0 million.
In the second quarter of fiscal 2005, we recorded an
additional loss on sale of $0.9 million due to subsequent adjustments to the working capital balances used to determine the purchase price. There may
be additional future losses to record based on the resolution of certain contingencies related to the sale. However, we are not able to estimate the
amount of any such losses at this time.
The financial results of our BroadAccess40,
Cuda/FastFlow, Singl.eview and Metrica businesses included in discontinued operations are as follows (in millions):
|
|
|
|
Three Months Ended
|
|
Six Months Ended
|
|
|
|
|
|
April 29, 2005
|
|
April 30, 2004
|
|
April 29, 2005
|
|
April 30, 2004
|
Net
sales |
|
|
|
$ |
— |
|
|
$ |
28.5 |
|
|
$ |
0.9 |
|
|
$ |
65.3 |
|
(Loss) Income
from discontinued operations |
|
|
|
$ |
(0.2 |
) |
|
$ |
(24.8 |
) |
|
$ |
2.5 |
|
|
$ |
(39.9 |
) |
Gain (Loss) on
sale of subsidiaries |
|
|
|
|
(0.9 |
) |
|
|
1.3 |
|
|
|
35.3 |
|
|
|
(2.3 |
) |
(Loss) Income
from discontinued operations, net of tax |
|
|
|
$ |
(1.1 |
) |
|
$ |
(23.5 |
) |
|
$ |
37.8 |
|
|
$ |
(42.2 |
) |
23
Application of Critical Accounting Policies and Estimates
There were no significant changes to our critical
accounting policies during the three and six months ended April 29, 2005. See our most recent Annual Report filed on Form 10-K for fiscal 2004 for a
discussion of our critical accounting policies.
Liquidity and Capital Resources
Cash & Short-Term Investments
Cash and cash equivalents and available for sale
securities were $567.0 million at April 29, 2005, or an increase of $38.6 million compared to October 31, 2004. The major source of cash during the
first six months of fiscal 2005 was net income from continuing operations, $16.7 million in proceeds from the net disposal of property and equipment,
$9.0 million related to the sale of a note receivable and $33.6 million related to proceeds from the sale of our Metrica service assurance software
group. This source of cash was partially offset by an increase in inventory and accounts receivable caused by the manufacture and sales of FTTX and
wireless products and a $20.5 million reduction in accrued liabilities, primarily for restructuring and incentive payments.
Auction rate securities reclassified from cash and
cash equivalents to current available-for-sale securities as of October 31, 2004 were $427.3 million. Certain prior year amounts have been reclassified
to conform to the current year presentation. These reclassifications have no effect on reported earnings.
As of April 29, 2005, we had restricted cash of
$19.1 million compared to $21.9 million as of October 31, 2004, a decrease of $2.8 million. The majority of our restricted cash represents collateral
for letters of credit and lease obligations. Restricted cash is expected to become available to us upon satisfaction of the obligations pursuant to
which the letters of credit or guarantees were issued. We are entitled to the interest earnings on our restricted cash balances.
Finance-Related Transactions
As of April 29, 2005, we had $400.0 million of
convertible unsecured subordinated notes, consisting of $200.0 million in 1.0% fixed rate convertible unsecured subordinated notes maturing on June 15,
2008, and $200.0 million of convertible unsecured subordinated notes with a variable interest rate and maturing on June 15, 2013. The interest rate for
the variable rate notes is equal to the 6-month LIBOR plus 0.375%. The interest rate for the variable rate notes will be reset on each semi-annual
interest payment date (i.e., which are June 15 and December 15 of each year beginning on December 15, 2003 for both the fixed and variable rate notes).
The interest rate on the variable rate notes is 3.065% for the current six-month period ending June 15, 2005. The holders of both the fixed and
variable rate notes may convert all or some of their notes into shares of our common stock at any time prior to maturity at a conversion price of
$28.091 per share. We may not redeem the fixed rate notes anytime prior to their maturity date. We may redeem any or all of the variable rate notes at
any time on or after June 23, 2008.
Vendor Financing
We have worked with customers and third-party
financiers to find a means to finance projects by negotiating financing arrangements. As of April 29, 2005 and April 30, 2004, we had fully drawn
commitments to extend credit of $1.7 million and $18.2 million for such arrangements, respectively. The decrease in vendor financing is due to the sale
of a significant note receivable in the three months ended January 28, 2005. The commitments to extend credit are conditional agreements generally
having fixed expiration or termination dates and specific interest rates, conditions and purposes. These commitments may expire without being drawn. We
regularly review all outstanding commitments, and the results of these reviews are considered in assessing the overall risk for possible credit losses.
At April 29, 2005, we have recorded $1.7 million in loss reserves in the event of non-performance related to these financing
arrangements.
24
Working Capital and Liquidity Outlook
Our main source of liquidity continues to be our
unrestricted cash and our current available-for-sale securities. We expect that we will be able to generate an increase in cash from operations for the
remainder of fiscal 2005. This is because we expect our income to remain at high levels while we expect cash required to support working capital
requirements to moderate in light of our expectation that sales the remainder of the fiscal year may not grow at the same high sequential rates we
experienced during the first six months of fiscal 2005. As such, we believe that our unrestricted cash and our current available-for-sale securities
should be adequate to fund our working capital requirements, planned capital expenditures and restructuring costs through fiscal 2005. If we are able
to maintain break-even or positive cash flow from operations, our existing cash should be adequate to fund such expenditures for several
years.
We believe that our entire restructuring accrual of
$30.0 million as of April 29, 2005 will be paid from our unrestricted cash as follows:
• |
|
$5.0 million for employee severance will be paid by the end of
the first quarter of fiscal 2006; |
• |
|
$8.7 million for facilities consolidation costs, which relate
principally to excess leased facilities, will be paid by the end of the first quarter in fiscal 2006; and |
• |
|
the remainder of $16.3 million, which also relates to excess
leased facilities, will be paid over the respective lease terms ending through 2015. |
We also believe that our unrestricted cash on hand
will also enable us to pursue strategic opportunities, including possible product line or business acquisitions. However, if the cost of one or more
acquisition opportunities exceeds our existing capital resources, additional sources of capital may be required. We do not currently have any committed
lines of credit or other available credit facilities, and it is uncertain whether such facilities could be obtained in sufficient amounts or on
acceptable terms. Any plan to raise additional capital may involve an equity-based or equity-linked financing, such as another issuance of convertible
debt or the issuance of common stock or preferred stock, which would be dilutive to existing shareholders.
Our $200 million of convertible notes do not mature
until June 15, 2008, and the other $200 million of convertible notes do not mature until June 15, 2013. All convertible notes have a conversion price
of $28.091 per share. In addition, our deferred tax assets, which are nearly fully reserved at this time, should reduce our income tax payable on
taxable earnings in future years.
Cautionary Statement Regarding Forward Looking Information
The foregoing Management’s Discussion and
Analysis of Financial Condition and Results of Operations, as well as the Notes to the Condensed Consolidated Financial Statements, contain various
“forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended. Forward-looking statements represent our expectations or beliefs concerning future events, including but not limited
to the following: any statements regarding future sales; profit percentages; earnings per share and other results of operations; our estimates of
probable liabilities relating to pending litigation; the continuation of historical trends; the sufficiency of our cash balances and cash generated
from operating and financing activities for our future liquidity; and capital resource needs and the effect of regulatory changes. We caution that any
forward-looking statements made by us in this report or in other announcements made by us are qualified by important factors that could cause actual
results to differ materially from those in the forward-looking statements. These factors include, without limitation: the magnitude and duration of the
recovery from the significant downturn in the communications equipment industry which began in 2001, particularly with respect to the demand for
equipment by telecommunication service providers, from which a majority of our sales are derived; our ability to restructure our business to achieve
and maintain operating profitability; macroeconomic factors that influence the demand for telecommunications services and the consequent demand for
communications equipment; possible consolidation among our customers, competitors or vendors which could cause disruption in our customer relationships
or displacement of us as an equipment vendor to the surviving entity in a customer consolidation; our ability to keep pace with rapid technological
change in our industry; our ability to make the proper strategic choices with respect to product line acquisitions or divestitures; our ability to
integrate the operations of any acquired
25
businesses with our own operations; increased
competition within our industry and increased pricing pressure from our customers; our dependence on relatively few customers for a majority of our
sales as well as potential sales growth in market segments we presently feel have the greatest growth potential; fluctuations in our operating results
from quarter-to-quarter, which are influenced by many factors outside of our control, including variations in demand for particular products in our
portfolio which have varying profit margins; the impact of regulatory changes on our customers’ willingness to make capital expenditures for our
equipment and services; financial problems, work interruptions in operations or other difficulties faced by some of our customers, which can influence
future sales to these customers as well as our ability to collect amounts due us; economic and regulatory conditions outside of the United States, as
approximately 47.4% of our sales come from non-U.S. jurisdictions; our ability to protect our intellectual property rights and defend against
infringement claims made by third parties; possible limitations on our ability to raise additional capital if required, either due to unfavorable
market conditions, lack of investor demand or the current corporate charter limitation on our ability to issue additional shares of common stock; our
ability to attract and retain qualified employees; our ability to maintain key competencies during a period of reduced resources and restructuring;
potential liabilities that could arise if there are design or manufacturing defects with respect to any of our products; our ability to obtain raw
materials and components, and our increased dependence on contract manufacturers to make certain of our products; changes in interest rates, foreign
currency exchange rates and equity securities prices, all of which will impact our operating results; our ability to successfully defend or
satisfactorily settle our pending litigation; and other risks and uncertainties, including those identified in Exhibit 99 to this Form 10-Q, which is
incorporated by reference herein. We disclaim any intention or obligation to update or revise any forward-looking statements.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to market risk from changes in
security prices, foreign currency exchange rates and interest rates. Market fluctuations could affect our results of operations and financial condition
adversely. We, at times, reduce this risk through the use of derivative financial instruments. We do not enter into derivative financial instruments
for the purpose of speculation.
We are exposed to interest rate risk as a result of
issuing $200.0 million of convertible unsecured subordinated notes on June 4, 2003 that have a variable interest rate. The interest rate on these notes
is equal to 6-month LIBOR plus 0.375%. The interest rate on these notes is reset semiannually on each interest payment date, which is June 15 and
December 15 of each year until their maturity in fiscal 2013. The interest rate for the current six-month period ending June 15, 2005 is 3.065%.
Assuming interest rates rise an additional 1%, 5% and 10%, our annual interest expense would increase by $2.0 million, $10.0 million and $20.0 million,
respectively.
We offer a non-qualified 401(k) excess plan to allow
certain executives to defer earnings in excess of the annual individual contribution and compensation limits on 401(k) plans imposed by the U.S.
Internal Revenue Code. Under this plan, the salary deferrals and our matching contributions are not placed in a separate fund or trust account. Rather,
the deferrals represent our unsecured general obligation to pay the balance owing to the executives upon termination of their employment. In addition,
the executives are able to elect to have their account balances indexed to a variety of diversified mutual funds (stock, bond and balanced), as well as
to our common stock. Accordingly, our outstanding deferred compensation obligation under this plan is subject to market risk. As of April 29, 2005, our
outstanding deferred compensation obligation related to the 401(k) excess plan was $4.2 million, of which $0.7 million was indexed to ADC common stock.
Assuming a 20%, 50% and 100% aggregate increase in the value of the investment alternatives to which the account balances may be indexed, our
outstanding deferred compensation obligation would increase by $0.8 million, $2.1 million and $4.2 million, respectively, and we would incur an expense
of a like amount.
We are exposed to market risk from changes in
foreign exchange rates. Our primary risk is the effect of foreign exchange rate fluctuations on the U.S. dollar value of foreign currency denominated
operating sales and expenses. Our largest exposure comes from the Mexican peso. The result of a 10% strengthening in the U.S. dollar to Mexican peso
denominated sales and expenses would result in an increase in operating income of $0.9 million for the quarter ended April 29, 2005. We are also
exposed to foreign currency exchange risk as a result of changes in intercompany balance sheet accounts and other balance sheet items. At April 29,
2005, principal currencies hedged included the Australian dollar, British pound, Canadian dollar, euro and Mexican peso. Hedging strategies
include:
26
• |
|
The use of foreign currency forwards and options to hedge a
portion of anticipated future sales and expenses denominated in foreign currencies, principally the Australian dollar, British pound, Canadian dollar,
euro and Mexican peso, in order to offset the effect of changes in exchange rates. |
• |
|
The use of foreign currency forwards and options to hedge
certain foreign denominated intercompany receivables, primarily in the Australian dollar, British pound, Canadian dollar, euro and Mexican peso, in
order to offset the effect on earnings of changes in exchange rates until these receivables are collected. |
CONTROLS AND PROCEDURES
Under the supervision and with the participation of
our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), we evaluated the effectiveness
of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the
“Exchange Act”)). Based on that evaluation, our CEO and CFO have concluded that, as of the end of the period covered by this report, our
disclosure controls and procedures were effective. During the period covered by this Quarterly Report on Form 10-Q, there was no change in our internal
control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting.
LEGAL PROCEEDINGS
On May 19, 2003, we were served with a lawsuit that
was filed in the United States District Court for the District of Minnesota. The complaint names ADC and several of our current and former officers,
employees and directors as defendants. After this lawsuit was served, we were served with two substantially similar lawsuits. All three of these
lawsuits were consolidated into a single lawsuit captioned In Re ADC Telecommunications, Inc. ERISA Litigation. This lawsuit has been brought by
individuals who seek to represent a class of participants in our Retirement Savings Plan who purchased our common stock as one of the investment
alternatives under the Retirement Savings Plan from February 2000 to present. The lawsuit alleges a breach of fiduciary duties under the Employee
Retirement Income Security Act. On February 2, 2004, we filed a motion to dismiss this lawsuit, which was denied by the court. This case is now in the
discovery phase. The class has not yet been certified.
On June 6, 2005, the Eighth Circuit Court of Appeals
upheld a decision of the United States District Court for the District of Minnesota to dismiss another class action suit brought against us. This
lawsuit was brought by Wanda Kinermon in March 2003. The complaint also named ADC, William J. Cadogan, our former Chairman and Chief Executive Officer,
and Robert E. Switz, our current Chief Executive Officer and former Chief Financial Officer, as defendants. After this lawsuit was served, we were
named as a defendant in 11 other substantially similar lawsuits. These shareowner lawsuits, including the suit brought by Ms. Kinermon, were
consolidated into a single lawsuit captioned In Re ADC Telecommunications, Inc. Securities Litigation. The lawsuit purported to bring suit on
behalf of a class of purchasers of our publicly traded securities from August 17, 2000 to March 28, 2001. The complaint alleged that we violated the
securities laws by making false and misleading statements about our financial performance and business prospects during this period. It is unclear at
this time whether plaintiffs will attempt to appeal.
We are a party to various lawsuits, proceedings and
claims arising in the ordinary course of business or otherwise. As of April 29, 2005, we had recorded $5.4 million in loss reserves in the event of
such adverse outcomes in these matters. At this time, we believe the ultimate resolution of these lawsuits, proceedings and claims will not have a
material adverse impact on our business, results of operations or financial condition. However, litigation by its nature is uncertain, and we cannot
predict the ultimate outcome of these matters, or any potential liability associated with the same, with any certainty.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Our annual meeting of shareowners was held on March
1, 2005. All of the vote totals set forth below have not been adjusted for our one-for-seven reverse stock split that became effective on May 10,
2005.
27
At the annual meeting, James C. Castle, Mickey P.
Foret, J. Kevin Gilligan and John D. Wunsch were elected as directors for terms expiring at the annual meeting of shareowners in 2008; William R.
Spivey was elected as a director for a term expiring at the annual meeting of shareowners in 2007; and Lois M. Martin and John Rehfeld were elected as
directors for terms expiring at the annual meeting of shareowners in 2006. The following table shows the vote totals with respect to the election of
these directors:
Name
|
|
|
|
Votes For
|
|
Authority Withheld
|
James C.
Castle, Ph.D. |
|
|
|
|
712,871,922 |
|
|
|
16,815,721 |
|
Mickey P.
Foret |
|
|
|
|
715,064,358 |
|
|
|
14,623,285 |
|
J. Kevin
Gilligan |
|
|
|
|
715,202,360 |
|
|
|
14,485,283 |
|
John D.
Wunsch |
|
|
|
|
708,198,931 |
|
|
|
21,488,712 |
|
William R.
Spivey |
|
|
|
|
714,868,220 |
|
|
|
14,819,423 |
|
Lois M.
Martin |
|
|
|
|
714,331,194 |
|
|
|
15,356,449 |
|
John E.
Rehfeld |
|
|
|
|
712,839,212 |
|
|
|
16,848,431 |
|
John J. Boyle III, Robert E. Switz and Larry W.
Wangberg continued as directors for terms expiring at the annual meeting of shareowners in 2007, and John A. Blanchard III, B. Kristine Johnson and
Jean-Pierre Rosso continued as directors for terms expiring at the annual meeting of shareowners in 2006.
At the annual meeting, our shareowners also approved
a proposal made by one of our shareowners requesting that our Board of Directors redeem our shareowner rights plan unless that plan is approved by our
shareowners. Approximately 35% of our total outstanding shares voted in favor this proposal. However, the votes in favor of this proposal represented a
majority of the shares that voted on the matter and as a result the proposal was approved under Minnesota law. The following table shows the vote
totals with respect to the proposal regarding our shareowner rights plan:
Votes For
|
|
|
|
Votes Against
|
|
Abstentions
|
Broker Non-Votes
|
|
282,315,049 |
|
|
|
|
140,514,134 |
|
|
|
9,617,461 |
|
|
297,240,999 |
|
At the annual meeting, our shareowners also ratified
the appointment of Ernst & Young LLP as our independent registered public accounting firm for the fiscal year ending October 31, 2005. The
following table shows the vote totals with respect to this ratification of Ernst & Young LLP as our independent registered public accounting
firm:
Votes For
|
|
|
|
Votes Against
|
|
Abstentions
|
716,202,234 |
|
|
|
|
7,072,319 |
|
|
|
6,413,090 |
|
RISK FACTORS
Our business faces many risks. The risks
described below may not be the only risks we face. Additional risks that we do not yet know of or that we currently think are immaterial may also
impair our business operations. If any of the events or circumstances described in the following risks actually occur, our business, financial
condition or results of operations could suffer, and the trading price of our common stock could decline.
Risks Related to Our Business
Our operating results have been adversely affected by the significant downturn
in the communications equipment industry and the slowdown in the United States economy.
Our operating results during the last four fiscal
years have been significantly impacted by the substantial downturn in the telecommunications equipment industry. In this market environment, many of
our customers reduced their equipment purchases and have deferred capital spending. Our customers are dependent on the level of end user demand for
communication services, and they are likely to continue to defer significant network expansions until there is greater demand for Internet, data, video
and voice services. As a result, our revenues decreased in fiscal 2003 and 2002; the increase in 2004 revenue was primarily because of our acquisition
of KRONE in May 2004. Our business also has been impacted negatively by reduced or deferred capital spending by customers outside the
telecommunications services field. Further, when our customers announce spending initiatives that might positively impact sales of one or more of our
products, it is possible the customers will contemporaneously reduce
28
spending in a manner that would negatively
impact other of our products. Some of our customers have experienced serious financial difficulties, including bankruptcy filings or cessation of
operations.
The general slowdown in the United States economy in
the last several years has also negatively impacted our business and operating results. While there is debate about the strength of an ongoing general
recovery in the overall economy and we have experienced revenue growth in fiscal 2004 and 2005, we expect any significant recovery in the
communications market to lag behind a general economic recovery. If general economic conditions in the United States and globally do not continue to
improve, or if there is a worsening of the United States or global economy, we may continue to experience material adverse effects on our business,
financial condition and results of operations.
We incurred significant net losses in fiscal 2003, 2002 and 2001. No assurance
can be given that we will consistently maintain operating profitability in the future.
We incurred losses from continuing operations of
$42.6 million, $980.2 million in fiscal 2003 and 2002, respectively. We also incurred significant losses in fiscal 2001. While we returned to
profitability in fiscal 2004, it is not clear that we will be able to continue to achieve revenue and gross margin levels needed to sustain
profitability.
When the significant reduction in communications
equipment spending became evident in fiscal 2001, we began implementing a restructuring plan to reduce operating expenses and capital expenditures and
to narrow the strategic focus of our business. As a result in large part of this restructuring plan, we incurred impairment and restructuring charges
of $14.0 million, $43.7 million and $543.1 million in fiscal years 2004, 2003 and 2002, respectively. Although most of the restructuring plan
initiatives have been implemented, we may be required to further restructure our business if we do not achieve sustained
profitability.
As a result of the restructuring plans, we have
significantly reduced expenses and lowered our quarterly revenue break-even point. However, we may not be able to achieve anticipated revenue levels in
future quarters or further reduce our expenses if revenue shortfalls occur. As a result, no assurance can be given that we will continue to achieve and
maintain operating profitability.
Shifts in our product mix may result in declines in gross profit, as a
percentage of net sales.
Our gross profit, as a percentage of net sales,
varies among our product groups. Our overall gross profit, as a percentage of net sales, has fluctuated from quarter to quarter as a result of shifts
in product mix (that is, how much of each product type we sell in any particular quarter), the introduction of new products, decreases in average
selling prices and our ability to reduce manufacturing costs. We expect such fluctuation in gross profit to continue in the future. Further, as KRONE
has historically sold certain products at margins lower than the margins at which our products have sold, the integration of KRONE’s business with
our own is likely to impact our gross profit levels. In addition, our gross margins could be lower based on the amount of new products we sell that
have lower startup gross margins.
Consolidation among our customers could result in our losing a customer or
experiencing a slowdown as integration takes place.
We believe it is likely that there will be increased
consolidation among our customers in order for them to increase market share, diversify product portfolios and achieve greater economies of scale.
Consolidation is likely to impact our business as our customers focus on integrating their operations and choosing their equipment vendors. After a
consolidation occurs, there can be no assurance that we will continue to supply equipment to the surviving communications service provider. The impact
of significant mergers on our business is likely to be unclear until sometime after such transactions have closed.
Our sales could be negatively impacted if one or more of our key customers
substantially reduce orders for our products.
Our customer base is relatively concentrated with
our top ten customers accounting for 46.3%, 55.3% and 54.1% of net sales for fiscal years 2004, 2003 and 2002, respectively. While our recent
acquisition of KRONE has diversified our customer base, if we lose a significant customer, our sales and gross margins would be negatively impacted.
Further, in the product areas where we believe the potential for revenue growth is most pronounced (e.g.
29
fiber-to-the-X initiatives and wireless
products), our sales remain highly concentrated with the large incumbent local exchange carriers. The loss of sales may require us to record additional
impairment and restructuring charges or exit a particular business or product line.
Our market is subject to rapid technological change, and to compete effectively,
we must continually introduce new products that achieve market acceptance.
The communications equipment industry is
characterized by rapid technological change. In our industry, we also face evolving industry standards, changing market conditions and frequent new
product and service introductions and enhancements by our competitors. The introduction of products using new technologies or the adoption of new
industry standards can make our existing products or products under development obsolete or unmarketable. For example, it is possible that
fiber-to-the-X initiatives may negatively impact sales of non-fiber products. In order to grow and remain competitive, we will need to adapt to these
rapidly changing technologies, to enhance our existing solutions and to introduce new solutions to address our customers’ changing
demands.
We may not accurately predict technological trends
or new products in the communications equipment market. New product development often requires long-term forecasting of market trends, development and
implementation of new technologies and processes and a substantial capital commitment. In addition, we do not know whether our products and services
will meet with market acceptance or be profitable. Many of our competitors have greater engineering and product development resources than us. Although
we expect to continue to invest substantial resources in product development activities, our efforts to achieve and maintain profitability will require
us to be more selective and focused with our research and development expenditures. If we fail to anticipate or respond in a cost-effective and timely
manner to technological developments, changes in industry standards or customer requirements, or if we have any significant delays in product
development or introduction, our business, operating results and financial condition could be materially adversely affected.
We may make additional strategic changes to our product portfolio, but our
strategic changes and restructuring programs may not yield the benefits that we expect.
In connection with the downturn in the
communications industry, we have divested or ceased operating numerous product lines and businesses that either were not profitable or did not match
our new strategic focus. As necessary, we may make further divestitures or closures of product lines and businesses. We also may make strategic
acquisitions.
The impact of potential changes to our product
portfolio and the effect of such changes on our business, operating results and financial condition, are unknown at this time. If we acquire other
businesses in our areas of strategic focus, we may have difficulty assimilating these businesses and their products, services, technologies and
personnel into our operations. These difficulties could disrupt our ongoing business, distract our management and workforce, increase our expenses and
adversely affect our operating results and financial condition. In addition to these integration risks, if we acquire new businesses, we may not
realize all of the anticipated benefits of these acquisitions, and we may not be able to retain key management, technical and sales personnel after an
acquisition. Divestitures or elimination of existing businesses or product lines could also have disruptive effects and may cause us to incur material
expenses.
If we seek to secure additional financing, we may not be able to obtain it.
Also, if we are able to secure additional financing, our shareowners may experience dilution of their ownership interest or we may be subject to
limitations on our operations.
We currently anticipate that our available cash
resources, which include existing cash and cash equivalents, will be sufficient to meet our anticipated needs for working capital and capital
expenditures for the remainder of fiscal 2005 and, if we are able to maintain breakeven or positive cash flow from operations, for the next several
years. If our estimates are incorrect and we are unable to generate sufficient cash flows from operations, we may need to raise additional funds. In
addition, if one or more of our strategic acquisition opportunities exceeds our existing resources, we may be required to seek additional capital. We
do not currently have any significant available lines of credit or other significant credit facilities, and we are not certain that we can obtain
commercial bank financing or, if it is available, whether it will be on acceptable terms. If we raise additional funds through the issuance of equity
or equity-related securities, our shareowners may experience dilution of their ownership interests, and
30
the newly issued securities may have rights
superior to those of common stock. See “Risks Related to our Common Stock” below. If we raise additional funds by issuing debt, we may be
subject to restrictive covenants that could limit our operating flexibility.
Our industry is highly competitive and subject to significant downward pressure
on the pricing for our products.
Competition in the communications equipment and
related services industry is intense. We believe our success in competing with other manufacturers of communications equipment products and related
services will depend primarily on our engineering, manufacturing and marketing skills, the price, quality and reliability of our products, our delivery
and service capabilities and our control of operating expenses. We have experienced and anticipate experiencing increasing pricing pressures from
current and future competitors as well as general pricing pressure from our customers as part of their cost containment efforts. Our industry is
currently characterized by many vendors pursuing relatively few and very large customers, which provides our customers with the ability to exert
significant pressure on their suppliers. Many of our competitors have more extensive engineering, manufacturing, marketing, financial and personnel
resources than us. As a result, other competitors may be able to respond more quickly to new or emerging technologies, changes in customer requirements
or offer more aggressive price reductions.
Possible consolidation among our competitors could result in a loss of
sales.
We expect to see continued consolidation among
communication equipment vendors. This can result in our competitors becoming financially stronger and obtaining broader product portfolios. It is
possible that such consolidation can lead to a loss of sales for us as our competitors increase their resources through consolidation.
Our operating results fluctuate significantly, and if we miss quarterly
financial expectations, our stock price could decline.
Our operating results are difficult to predict and
fluctuate significantly from quarter to quarter. It is likely that our operating results in some periods will be below investor expectations. If this
happens, the market price of our common stock is likely to decline. Fluctuations in our future quarterly earnings results may be caused by many
factors, including:
• |
|
the volume and timing of orders from and shipments to our
customers; |
• |
|
work stoppages and other developments affecting the operations
of our customers; |
• |
|
the timing of and our ability to obtain new customer contracts
and sales recognition; |
• |
|
the timing of new product and service announcements; |
• |
|
the availability of products and services; |
• |
|
the overall level of capital expenditures by our
customers; |
• |
|
the market acceptance of new and enhanced versions of our
products and services; |
• |
|
variations in the mix of products and services we
sell; |
• |
|
the utilization of our production capacity and employees;
and |
• |
|
the availability and cost of key components. |
Our expense levels are based in part on expectations
of future revenues. If revenue levels in a particular period are lower than expected, our operating results will be affected
adversely.
In addition, prior to fiscal 2001 and during fiscal
2004, our operating results were subject to seasonal factors. We historically have had stronger demand for our products and services in the fourth
fiscal quarter ending October 31, primarily as a result of our year-end incentives and customer budget cycles. We typically have experienced weaker
demand for our products and services in the first fiscal quarter ending the last Friday in January, primarily as a result of the number of holidays in
late November, December and early January, the development of annual capital budgets by our customers during that period and a general industry
slowdown during that period.
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Due to the economic downturn in the communications
equipment and services market, this historical trend of seasonality was not evident during fiscal years 2001-2003. Our historical seasonal pattern
returned in fiscal 2004 and we presently expect it to continue in fiscal 2005.
The regulatory environment in which our customers operate is
changing.
Although our business is not subject to a
significant amount of direct regulation, the communications service industry in which our customers operate is subject to significant federal and state
regulation in the United States as well as regulation in other countries. In early 1996, the United States Telecommunications Act of 1996 was enacted.
This Act lifted certain restrictions on the ability of companies, including the major telephone companies and other ADC customers, to compete with one
another. The Act also made other significant changes in the regulation of the telecommunications industry. These changes generally have increased our
opportunities to provide solutions for our customers’ Internet, data, video and voice needs.
However, the established telecommunications
providers have stated that some of these changes have diminished the profitability of additional investments made by them in their networks, which
reduces their demand for our products. On February 20, 2003, the Federal Communications Committee (“FCC”) adopted rules under the
Telecommunications Act concerning the obligation of the established telecommunication service providers to share their networks with competitors, a
practice known as “unbundling.” The FCC essentially retained the existing unbundling obligations of the carriers with respect to their
historic copper-based network infrastructure, and ruled not to require the unbundling of certain network elements in their next generation hybrid and
fiber networks. In August 2003, the FCC issued its final rules on these unbundling obligations and in October 2004 conclusively affirmed that the major
telephone companies are not required to unbundle their networks for the provision of fiber-based services all the way or almost all the way to end user
premises. In turn, several major telephone companies have stated their intention to increase capital spending on fiber-to-the-X
initiatives.
Future regulatory changes affecting the
communications industry are anticipated both in the United States and internationally. These changes could affect our customers and alter demand for
our products. Recently announced or future changes could also come under legal challenge and be altered, thereby reversing the effect the initial
announcement of changes was expected to have on our business. In addition, competition in our markets could intensify as the result of changes to
existing regulations or new regulations. Accordingly, changes in the regulatory environment could adversely affect our business and results of
operations.
Customer payment defaults could have an adverse effect on our financial
condition and results of operations.
As a result of adverse conditions in the
communications market, some of our customers have and may continue to experience serious financial difficulties, which in some cases have resulted or
may result in bankruptcy filings or cessation of operations. In the future, if customers experiencing financial problems default and fail to pay
amounts owed to us, we may not be able to collect these amounts or recognize expected revenue. In the current environment in the communications
equipment and related services industry and the United States and global economy, it is possible that customers from whom we expect to derive
substantial revenue will default or that the level of defaults will increase. Any material payment defaults by our customers would have an adverse
effect on our results of operations and financial condition.
In the past, we also have provided financing to some
of our customers for purchases of our equipment. We have not closed on a transaction where new financing was made available to a customer, however,
since 2003.
Many of our competitors engage in similar financing
transactions in order to obtain customer orders. To remain competitive, we believe that it may be necessary for us to continue to offer financing
arrangements in the future. We intend under certain circumstances to sell all or a portion of these commitments and outstanding receivables to third
parties. In the past, we have sold some receivables with recourse and have had to compensate the purchaser for the loss.
Our ability to collect on these financing
arrangements is contingent on the financial health of the companies to which we extend credit. The condition of these companies is affected by many
factors, including, among others, general conditions in the communications equipment and services industry, general economic conditions
and
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changes in telecommunications regulations. We
may experience credit losses that could adversely affect our operating results and financial condition.
Conditions in global markets could affect our operations.
Our non-United States sales accounted for
approximately 40.4%, 26.0% and 20.2% of our net sales in fiscal 2004, 2003 and 2002, respectively. We expect non-United States sales to remain a
significant percentage of net sales in the future. In fact, absent additional acquisitions or divestitures, we expect our acquisition of KRONE to cause
our non-United States sales to represent approximately one-half our net sales. In addition to sales and distribution in numerous countries, we own or
lease operations located in Austria, Australia, Belgium, Brazil, Canada, Chile, China, France, Germany, Hungary, India, Indonesia, Italy, Japan,
Malaysia, Mexico, New Zealand, Norway, Philippines, Puerto Rico, Russia, Singapore, South Africa, South Korea, Spain, Taiwan, Thailand, the United Arab
Emirates, the United Kingdom, the United States, Venezuela and Vietnam. Due to our non-United States sales and our non-United States operations, we are
subject to the risks of conducting business globally. These risks include:
• |
|
local economic and market conditions; |
• |
|
political and economic instability; |
• |
|
unexpected changes in or impositions of legislative or
regulatory requirements; |
• |
|
fluctuations in foreign currency exchange rates; |
• |
|
tariffs and other barriers and restrictions; |
• |
|
difficulties in enforcing intellectual property and contract
rights; |
• |
|
greater difficulty in accounts receivable
collection; |
• |
|
potentially adverse taxes; and |
• |
|
the burdens of complying with a variety of non-United States
laws and telecommunications standards. |
We also are subject to general geopolitical and
environmental risks, such as terrorism, political and economic instability, changes in diplomatic or trade relationships and natural disasters. We
maintain business operations and have sales in many non-United States markets. Economic conditions in many of these markets represent significant risks
to us. We cannot predict whether our sales and business operations in these markets will be affected adversely by these conditions.
Instability in non-United States markets, which we
believe is most likely to occur in the Middle East, Asia and Latin America, could have a negative impact on our business, financial condition and
operating results. The wars in Afghanistan and Iraq and other turmoil in the Middle East and the global war on terror also may have negative effects on
the operating results of some of our businesses. In addition to the effect of global economic instability on non-United States sales, sales to United
States customers having significant non-United States operations could be impacted negatively by these conditions.
Our intellectual property rights may not be adequate to protect our
business.
Our future success depends in part upon our
proprietary technology. Although we attempt to protect our proprietary technology through patents, trademarks, copyrights and trade secrets, these
protections are limited. Accordingly, we cannot predict whether such protection will be adequate, or whether our competitors can develop similar
technology independently without violating our proprietary rights.
Also, rights that may be granted under any patent
application in the future may not provide competitive advantages to us. Intellectual property protection in foreign jurisdictions may be limited or
unavailable. In addition, many of our competitors have substantially larger portfolios of patents and other intellectual property rights than
us.
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As the competition in the communications equipment
industry increases and the functionality of the products in this industry further overlaps, we believe that companies in the communications equipment
industry are becoming increasingly subject to infringement claims. We have received and may continue to receive notices from third parties, including
some of our competitors, claiming that we are infringing third-party patents or other proprietary rights. We cannot predict whether we will prevail in
any litigation over third-party claims, or whether we will be able to license any valid and infringed patents on commercially reasonable terms. It is
possible that unfavorable resolution of such litigation could have a material adverse effect on our business, results of operations or financial
condition. Any of these claims, whether with or without merit, could result in costly litigation, divert our management’s time, attention and
resources, delay our product shipments or require us to enter into royalty or licensing agreements, which could be expensive. A third party may not be
willing to enter into a royalty or licensing agreement on acceptable terms, if at all. If a claim of product infringement against us is successful and
we fail to obtain a license or develop or license non-infringing technology, our business, financial condition and operating results could be affected
adversely.
We are dependent upon key personnel.
Like all technology companies, our success is
dependent on the efforts and abilities of our employees. Our ability to attract, retain and motivate skilled employees is critical to our success. In
addition, because we may acquire one or more businesses in the future, our success will depend, in part, upon our ability to retain and integrate our
own personnel with personnel from acquired entities who are necessary to the continued success or the successful integration of the acquired
businesses.
Our recent initiatives to focus our business on core
operations and products by restructuring and streamlining operations, including substantial reductions in our workforce, have created uncertainty on
the part of our employees regarding future employment with us. This uncertainty, together with our operating losses and lower stock price, may have an
adverse effect on our ability to retain and attract key personnel.
Internal Controls under Sarbanes-Oxley Act of 2002.
Pursuant to Section 404 of the Sarbanes-Oxley Act of
2002, we will be required, beginning with our fiscal year ending October 31, 2005, to include in our annual report our assessment of the effectiveness
of our internal control over financial reporting as of the end of fiscal 2005. Furthermore, our independent registered public accounting firm will be
required to attest to whether our assessment of the effectiveness of our internal control over financial reporting is fairly stated in all material
respects and separately report on whether it believes we maintained, in all material respects, effective internal control over financial reporting as
of October 31, 2005. We presently are implementing a plan designed to assure compliance with these new requirements, but we have not yet completed our
assessment of the effectiveness of our internal control over financial reporting. If we fail to timely complete this assessment, or if our independent
registered public accounting firm cannot timely attest to our assessment, we could be subject to regulatory sanctions and a loss of public confidence
in our internal control over financial reporting. In addition, any failure to implement required new or improved controls, or difficulties encountered
in their implementation, could harm our operating results or cause us to fail to meet our regulatory reporting obligations timely.
Product defects could cause us to lose customers and revenue or to incur
unexpected expenses.
If our products do not meet our customers’
performance requirements, our customer relationships may suffer. Also, our products may contain defects. Any failure or poor performance of our
products could result in:
• |
|
delayed market acceptance of our products; |
• |
|
delays in product shipments; |
• |
|
unexpected expenses and diversion of resources to replace
defective products or identify the source of errors and correct them; |
• |
|
damage to our reputation and our customer
relationships; |
• |
|
delayed recognition of sales or reduced sales; and |
34
• |
|
product liability claims or other claims for damages that may be
caused by any product defects or performance failures. |
Our products are often critical to the performance
of communication systems. Many of our supply agreements contain limited warranty provisions. If these contractual limitations are unenforceable in a
particular jurisdiction or if we are exposed to product liability claims that are not covered by insurance, a successful claim could harm our
business.
We may encounter difficulties obtaining raw materials and supplies needed to
make our products.
Our ability to produce our products is dependent
upon the availability of certain raw materials and supplies. The availability of these raw materials and supplies is subject to market forces beyond
our control. From time to time, there may not be sufficient quantities of raw materials and supplies in the marketplace to meet the customer demand for
our products. In addition, the costs to obtain these raw materials and supplies are subject to price fluctuations because of global market demands.
Many companies utilize the same raw materials and supplies in the production of their products as we use in our products. Companies with more resources
than our own may have a competitive advantage in obtaining raw materials and supplies due to greater purchasing power. Reduced supply and higher prices
of raw materials and supplies may affect our business, operating results and financial condition adversely.
In addition, we have significant reliance on
contract manufacturers to make certain of our products on our behalf. If these contract manufacturers do not fulfill their obligations to us, or if we
do not properly manage these relationships, our existing customer relationships may suffer. We may outsource additional functions in the
future.
We have been named as a defendant in securities and other
litigation.
We have been named as a defendant in a purported
class action lawsuit alleging breach of fiduciary duties under ERISA. This case, In Re ADC Telecommunications, Inc. ERISA Litigation, has been
brought by individuals who seek to represent a class of participants in our Retirement Savings Plan who purchased our common stock as one of the
investment alternatives under the plan.
Litigation is by its nature uncertain and
unfavorable resolutions of these lawsuits could materially adversely affect our business, results of operations or financial
condition.
We are a party to various other lawsuits,
proceedings and claims arising in the ordinary course of business or otherwise. Many of these disputes may be resolved amicably without resort to
formal litigation. The amount of monetary liability resulting from the ultimate resolution of these matters cannot be determined at this time. As of
April 29, 2005, we had recorded approximately $5.4 million in loss reserves for these matters. Because of the uncertainty inherent in litigation, it is
possible that unfavorable resolutions of these lawsuits, proceedings and claims could exceed the amount currently reserved and could have a material
adverse affect on our business, results of operations or financial condition.
We are subject to risks associated with changes in security prices, interest
rates and foreign currency exchange rates.
We face market risks from changes in security prices
and interest rates. Market fluctuations could affect our results of operations and financial condition adversely. At times, we reduce this risk through
the use of derivative financial instruments. However, we do not enter into derivative instruments for the purpose of speculation.
Also, we are exposed to market risks from changes in
foreign currency exchange rates. From time to time, we hedge our foreign currency exchange risk. The objective of this program is to protect our net
monetary assets and liabilities in non-functional currencies from fluctuations due to movements in foreign currency exchange rates. We attempt to
minimize exposure to currencies in which hedging instruments are unavailable or prohibitively expensive by managing our operating activities and net
assets position. As a result of our increased international exposure due to the KRONE acquisition, we may hedge foreign currency exposures in the
future. At April 29, 2005, principal currencies hedged included the Australian dollar, British pound, Canadian dollar, euro and Mexican
peso.
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Risks Related to Our Common Stock
Our stock price is volatile.
Based on the trading history of our common stock and
the nature of the market for publicly traded securities of companies in our industry, we believe that some factors have caused and are likely to
continue to cause the market price of our common stock to fluctuate substantially. The fluctuations could occur from day-to-day or over a longer period
of time. The factors that may cause such fluctuations include:
• |
|
announcements of new products and services by us or our
competitors; |
• |
|
quarterly fluctuations in our financial results or the financial
results of our competitors or our customers; |
• |
|
customer contract awards to us or our competitors; |
• |
|
increased competition with our competitors or among our
customers; |
• |
|
consolidation among our competitors or customers; |
• |
|
disputes concerning intellectual property rights; |
• |
|
the financial health of ADC, our competitors or our
customers; |
• |
|
developments in telecommunications regulations; |
• |
|
general conditions in the communications equipment industry;
and |
• |
|
general economic conditions in the U.S. or
internationally. |
In addition, stocks of companies in our industry in
the past have experienced significant price and volume fluctuations that are often unrelated to the operating performance of such companies. This
market volatility may adversely affect the market price of our common stock.
We have not in the past and do not intend in the foreseeable future to pay cash
dividends on our common stock.
We currently do not pay any cash dividends on our
common stock and do not anticipate paying any cash dividends on our common stock in the foreseeable future. We intend to retain future earnings, if
any, to finance our operations and for general corporate purposes.
Anti-takeover provisions in our charter documents, our shareowner rights plan
and Minnesota law could prevent or delay a change in control of our company.
Provisions of our articles of incorporation and
bylaws, our shareowner rights plan (also known as a “poison pill”) and Minnesota law may discourage, delay or prevent a merger or acquisition
that a shareowner may consider favorable and may limit the market price for our common stock. These provisions include the following:
• |
|
advance notice requirements for shareowner
proposals; |
• |
|
authorization for our Board of Directors to issue preferred
stock without shareowner approval; |
• |
|
authorization for our Board of Directors to issue preferred
stock purchase rights upon a third party’s acquisition of 15% or more of our outstanding shares of common stock; and |
• |
|
limitations on business combinations with interested
shareowners. |
Some of these provisions may discourage a future
acquisition of ADC even though our shareowners would receive an attractive value for their shares or a significant number of our shareowners believed
such a proposed transaction would be in their best interest.
36